Investment Idea: Acacia Research Corp

(ACTG)

Intellectual Property: center of innovation and value creation in world economy

Patents are temporary monopolies protected by US constitution and issued by the United States Patent and Trademark Office (USPTO). Licensing in US has grown to a $500 billion industry in last 30 years Criteria for patent: has to be useful, novel and nonobvious (broad and somewhat vague more on this later) Controversy: the patent system has been abused by patent-trolls who use aggressive tactics to assert frivolous claims (more on this later)

IP is a strategic asset, licensing is a business

Companies are becoming more adept at exploiting their intellectual property
IP historically has been used as an entry barrier; firms that acquired and owned patents passively often licensing only to protect against anti-trust Today IP has become a growth driver and profit center

Patent dealers and NPEs are pure-play IP plays

Non-practicing entities secure patent portfolios and license them out through agreements to operating companies They can sue to protect from infringement without fear of being countersued

IP market remains inefficient and adversarial

No liquid exchange or transparent markets No price discovery mechanism / no information sharing or pooling of risk Differences in perceived value of patents and lack of signals often causes some participants to ignore market and gravitate towards litigation

Enter Non-Practicing Entities (NPEs)

The patent market has been extremely inefficient, and over time with any new asset class there will be a variety of business formats that rationalize the process that make the markets more efficient. Historically, the only way you can get paid for a patent, and pretty much 99% the way it is today, is you have to resort to the legal system in order to transact. You'd literally have to sue another company or they generally will not talk to you. And if you talk them inappropriately, they can countersue you. They can file a declaratory judgment against you for just offering a license. So the structure of the market place really requires a lot of enforcement. Fortunately, we're far enough down the road, we've done so many deals that we have legal arrangements with a lot of leading companies where both sides preserve their legal right and can enter into arms length of discussions without litigation. And we think we'll be moving more and more in that direction, which is great for our shareholders and great for our IP partners because it lessens the friction cost of all the lawyering, improves our margins. - Paul Ryan, CEO of Acacia

Acacia: a market maker and asset management company?

Patent aggregators, like Acacia, create liquidity, transparency and pricing signals to all participants ACTG is a Non-Practicing-Entity - which basically means it buys, sells, and licenses patents, but doesnt actually use its patents directly by manufacturing products / services Acacias goal is to add value through the management of a portfolio of assets through fundamental research, due-diligence, and deal-making in an effort to deliver good risk-adjusted returns in an inefficient market that is complex, illiquid, misunderstood, and ever-changing Acacia gets paid by monetizing IP for its clients and its owned portfolios. It coordinates campaigns and licensing programs and uses litigation as a backdrop to future agreements; however, as market matures and becomes more fluid there is less friction and less litigation

Business: A leader in patent licensing

Has 274 IP portfolios that have led to thousands and controls tens of thousands of patents Only 154 of their portfolios are licensed (most just partially with plenty of runway), creating a strong pipeline for revenue growth Selectively increasing AUM through structured partnership deals and focusing on +NPV portfolios drive excellent returns on capital Acacia is one of the most active active dealers in secondary markets Investments / partnerships in mobile, location-based-services, computer power management, flash memory, telematics, data storage has yielded great returns on capital Recent diversification into medical technology, automobile technologies and energy has huge potential

Strong track record

Investment philosophy: Value

They think like asset managers with an ROI mindset Not looking for home-runs; mainly singles and doubles Better information, brokers and market makers are emerging creating efficiencies in market. Acacia seeks portfolios that will provide predictable licensing revenues over uncertain litigation which can be costly, time-consuming and incredibly unpredictable Look to deploy capital, ink-deals and approach settlements taking into account timing of monetization / cashflows and magnitude (build DCFs for portfolios) IRR and NPV focused Eat risk-adjusted returns

Customer value proposition: monetization with low-risk and protection

ACTG provides a turn-key solution and acts like a proxy for patent authors and large companies to execute licensing agreements through subsidiaries without fear of IP countersuits It enables the monetization of non-core assets while avoiding the marketing / legal complexity of enforcement and marketing Use of comprehensive licensing agreements are becoming increasingly attractive for big firms. This represents a multibillion dollar opportunity for Acacia.

Management
Acacia employs 55 people in Newport, California. This is a human capital business as there is only a select few in the market that know how to effectively manage IP Organization is managed through an intersection of legal/IP and licensing experts (who underwrite the business development efforts), engineering & tech experts, and vertical specialists with extensive backgrounds in those fields CEO Paul Ryan is architect of IP strategy and operations. He has a Ph.D. and a legal/banking/VC background with top firms. Cornell B.S. and NYU MBA. Team includes dozens of VPs of Engineering and science/technology experts that typically have 15 20 years experience coming form firms like Intel, Nortel, Texas Instruments, Marvell, Sony, Schlumberger and dozens more All have good salaries, but are highly incentivized to close deals and sign license agreements through bonus structures. (management owns ~3% of company)

Investment thesis: a great asset class and attractive business model

Acacia is a key player in a fast growing market: first player in IP monetization sector Scope of portfolio, track-record and size makes Acacia the go-to company for operating companies looking to ink agreements that provide upside and protection Network effects in licensing / sourcing deals. IP portfolio AUM has more than doubled in two years Avoid litigation: over 1200+ licensing deals and settlements / only 4 trials in 10 years.

Business model and profile

Business model operates as follows: Company acquires patents from partners and places them in operating subsidiaries; They prepare the portfolio for licensing (e.g. review contracts, define portfolios, match patents with portfolios) which can take ~18 months; Launch of portfolio-specific revenue generating program; This results in licensing agreements / settlements for the portfolio, using litigation only when necessary (company has gone to trial 4 times in its history)

Business model and profile

Most licensing deals are one-off agreements that capture the economics for patents previously used and in current use Avoid royalties due to higher costs to enforce and oversee and belief that licensees will generate work-arounds. Avoid longtails ACTGs business model yields >50% PF gross margins and >40% PF operating margins (more recent 30% Op margins) Margins will further expand through:
Operating leverage / scale Mix shift towards hybrid & wholly owned portfolios Lower enforcement costs as model veers away from litigation

Flexibility in deal-making
Acacia generally follows three models: Partner Model 50/50 revenue share with patent owners, license to corporate users. Typical partners include corporations, research labs / universities, individuals Purchase Model 100% ownership. Typically bought from distressed situations and failed startups backed by VCs Hybrid Model Up front cash to partners and revenue share *Legal fees paid on contingent basis

Flexibility in deal-making
Partnership Model Purchase Model

Hybrid model
Consists of Acacia putting up capital to the original IP owner and recouping investment from first dollars out of licensing revenues Higher back-end participation This model is expected to be norm going forward for high-quality patents
Remains fairly capital light

Dozens of verticals
Advertising Internet / Ecommerce Communications Computers/Peripherals Consumer Electronics Database Digital Media Energy /Lighting Mechanical Medical Security Semiconductor Software Wireless

Return on portfolios has improved with time; pipeline strong

Many multiples of capital invested with a blended 40% yoy ROIC economic profile. Portfolios with plenty of runway for higher licensing turnover: Access/Palm (smartphone/wireless) Rambus (displays) Adaptix (wireless 4G / LTE) Nokia-Siemens (wireless infrastructure) Boston Scientific (medical: cardiac) Bonutti (medical: orthopedics) Renesas (semiconductors) Breed (automotive)

IP intake to replace maturing portfolios is also strong with dozens of portfolios added every year

Licensees
Pretty much every Fortune 100 company: AMD Boston Scientific Dell Exxon General Electric Hewlett Packard Hitachi IBM Intel LG Electronics Microsoft Nokia Samsung Sanyo Siemens And on and on..

Purchase Case study: Adaptix

Note: Capital intensity of deals varies according to type of deal structure (Partner / Purchase / Hybrid) but returns can be equally attractive for each Up front payment of ~$150 MM in 1Q of 2012 for a portfolio of 4G LTE standards patents (130+ patents) Immediately licensed out to Microsoft and Samsung for $65 million. Since deal closed, with three license deals, 2/3 of investment has been recouped (no litigation) Mgmt. expects full payback in 2013 and expects dozens of more licensing deals for next 10 years

They are busy

One months news, 19 licensing and settlement agreements (higher than historical rate in prior Qs):
Target Sams West Rite Aid Corp CVS Pharmacy CafPress Costco IBM Redhat Office Depot.and more

Stock provides Value

Stock Price: $24.50 Market Cap ~$1200 MM $327 MM in cash ($6.67 per share); no debt EV of ~$875 MM
6.50x on 2013 EBITDA 4.60x on 2014 EBITDA

Cash EPS >> GAAP EPS

2013 cash EPS of $2.25 (excludes amortization & non-cash comp)

Run-rate is $2.25+ next 3 years and $3.00 to $4.00 in next 5 yrs.

and Growth
ACTG has generated $936 million of high margin revenue since inception TTM revenue of $250 MM (CAGR of 39% over last six years) is still in early stages of monetization of its major portfolios that remain largely unlicensed Despite no official guidance, due to difficulty in timing of closing of deals and settlements, management expects its yearly growth to continue at its two-year ~35% run-rate

Valuation
An investment in Acacia is an investment in the firms intellectual capital and intangible assets The IP intangible assets ACTG uses to generate cashflow can have wide ranges of potential value (from conservative to aggressive) Trying to value each portfolio is very difficult; however, understanding its key portfolios is helpful while also looking at trends such as monetization rates, revenue per portfolio, and deal size / structure Each portfolio, on average, should have somewhat predictable return characteristics

Valuation
Method: Monetized IP + Un-monetized IP + New IP Slightly >50% of portfolios are generating revenues, but only ~40% of ultimate value has been extracted (it takes 5 7 years to fully license a typical portfolio) Historical monetization rates / timing to gross up can give a ballpark idea of the NPV of a new portfolio Finally, a big driver we also assign value to, is unsecured new IP that will be acquired through purchase / partner / hybrid models and generate attractive returns on capital

Assumptions
Current portfolios: ~$936 MM of total revenues ITD;
Implied revenue per portfolio ~$5 MM; ~40% of value extracted; grossed up portfolio is $13 MM Results in a gross rev potential of approximately $2,000 MM

Unmonetized portfolios:
106 of which higher proportion is fully owned; assign $22 MM per portfolio (larger deal sizes in recent years will mature) which leads to a gross portfolio potential of approximately $2,300 MM

Future IP portfolios:
Using historical data assume 100 portfolios with superior economics considering larger size, scope and hybrid model being used (with higher implied investment) $30 MM is conservative which leads to a gross estimate of $3,000 MM

SOTP Assumptions
*all figures in MM except per share figures Gross Port Rev 65% GM % un-harvested Gross Profit Total Gross Profit Cum 5 yr. OpEx Capital Investment Cum Profits (35% tax rate) Discounted Enterprise Value per share (see next slide) Cash on balance sheet Equity Value per share Current $2000 $1300 60% $780 $4225 $550 $400 $2128 $32.00 $327 $38.64 Un-monetized $2300 $1495 100% $1495 New IP $3000 $1950 100% $1950

Timing of revenues is uncertain, but

Licensing agreements are nearly impossible to time, and thus a DCF model is hard to construct, however maturity of the portfolio does suggest that peak CFs will occur in the next 3 - 4 years (for currently owned portfolios) Using a duration weighted discount on cumulative CFs lead us to a fair value stock price of $38.00 per share in 2013 and over $50 per share 3 years out Bottom line: ACTG will generate a $300 to $400 MM growing revenue stream for next 5+ years and will easily generate $2, $3, and $4 dollars of earnings per year

Why is the stock cheap?

Misunderstood; stability of business model is underrated Revenues are lumpy quarter to quarter making it nearly impossible for analysts to model out (but consistent over yearly time-frames) No guidance (strategic disadvantage and conflict in negotiating process with licensees) Headline noise creates fear: stock gets killed each time there is a headline that patent system might get reformed (truth is every single political / legislative initiative has actually strengthened ACTGs business)

Sowhats not to like?

They dont actually produce anything themselves. Theyre just trying to essentially leverage and hijack someone elses innovation to see if they can extort some money out of them.
- President Barack Obama on so-called patent trolls

What is a true patent troll, why are they so hated?

True patent trolls are a subset of NPEs that use malicious tactics to getting paid. Some of these tactics include: Marketing low quality garbage patents: enforcing broad and poorly designed, arguably worthless, patents on small and mom and pop businesses Shaking down vulnerable downstream businesses: threats of expensive litigation force profitable businesses to settle and avoid nuisance Jurisdictional nirvana: setting up fake offices in patent friendly jurisdictions and targeting unsuspecting businesses (again arguing ridiculously broad claims) Privateering: use of obscure holding companies with fake offices to hide the true ownership of patents

Market is afraid of trolls

Perception: Trolls ruthless tactics and focus on end-users, rather than manufactures, overwhelms legal system and hurts innocent entrepreneurial bystanders. This hurts innovation and the economy. Reality: Patents are a property right that fuels the drive of inventors, universities and R&D groups. Weakening these rights by discriminating against those that legally own them (paid for them) flouts on the principle of equality under the law. The protection patents provide drive research and innovation.

Reality: Patents, while imperfect, are a critical part of todays economy

Over last 100 years the US economy has transitioned from a manufacturing economy, to a service economy, and now to a knowledge economy Startups, individual inventors, and small and large companies conducting R&D are significant drivers of economic growth Go to market / direct enforcement for IP isnt always possible or practical for small firms; using licensing firms, like Acacia, to capitalize on what is theirs actually promotes innovation and growth

Reality: Risks of going to court are high for everyone involved

The risks of going to trial, particularly in plaintifffriendly courts, can be huge which often makes disputes often get resolved through settlements and licensing agreements But infringement is infringement is infringement Use of litigation as a first step is still often necessary, but 99% of these reach an agreement due to compelling evidence of breach

Alphabet soup of legislative and lobbying initiatives

Like most complex issues, the truth lies somewhere in the middle, yet politicians and interested parties go to the extreme The two sides can be broken down into the Googles of the world, who want intellectual property to be royalty and license free to encourage innovation. AKA the anti-IP group. On the other side, there are the legal advocates of property rights and R&D heavy organizations/entities like universities, the GEs of the world, and true technology / medical industries that need protection from the innovations they create through the patent system Net net, the anti-IP agenda is outgunned

Executive branch rhetoric wont lead to significant legislation

Shield Act is redundant and wont pass Patent Act is strong and already provides protection against frivolous lawsuits which, in turn, promotes focus on high-quality patents Existing law, if properly enforced, already gives courts mechanism and leeway to dismiss cases America Invents Act allows post-grant proceedings but they are limited to invalidity issues only (another deterrent to weak claims) Rule 11: legal system needs reform, not patent industry

Innovation violates tradition attacks it in public and steals from it in private. Mason Cooley

Summary
Contrarian idea with good risk/reward: investment isnt for everyone headlines will create volatility. Risk of persecution from government cant be dismissed Capital light; high ROIC business w plenty of runway to reinvest in profitable growth (optionality upside) Cheap with very strong growth potential Strong balance sheet with >25% of mkt cap in cash Operating leverage in an asset class and market that is growing No direct competition; structural advantages over fragmented one / two man shops Eat their own cooking: management wins when shareholders win